Why Interest Rates Need to Rise

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Really, why do interest rates need to rise when prices of everything else is going up too?

You might be feeling the cost of living rising everywhere, from gadgets, food, fuel for your car and your utility bills. You are feeling the stretch. With the price of everything going up, the last thing you need is the cost of your mortgage also going up.

Why oh, why does the central bank want to make life harder for everyone, and lift interest rates, when we are facing cost pressures in the first place?

The answer requires a bit of an explainer of how money, inflation, and the economy works as well as an understanding of a couple of key economic concepts.

Most of us know that too much inflation, is not a good thing. But exactly where does inflation come from?

This brings us to our first economic concept — “Inflation is always and everywhere a monetary phenomenon”, famously quoted by economist Milton Friedman. What it essentially means is that when there is inflation it has almost always been preceded by an increase in the supply of money.

A famous case study on how inflation works involved prisons where cigarettes are used as ‘money’ to exchange goods and services. When cigarettes were distributed to the prisoners each week, the supply of cigarettes in the system of that prison increased and the price of everything (in cigarettes) went up. Towards the end of the week, when there were less cigarettes in circulation as prisoners smoked them, what happened to the “market” price of goods and services? They fell. There are real world examples throughout history. The hyperinflation periods in Germany post World War I and Zimbabwe in the last decade are standouts when governments underwent a period of excessive spending and led to a significant increase in the supply of money.

So, the theory goes that the money supply has an impact on inflation. Central banks generally don’t directly control the money supply, but they do use interest rate targets and other monetary policy tools to influence the supply of money and hope to influence inflation that way. The real world is also more complicated than the prison example, and it doesn’t say much about the demand for money and demand in the economy.

In the darkest days of the pandemic when lockdowns were widespread across the world, central banks unleashed unprecedented monetary stimulus by bringing down interest rate targets and adopting asset purchases. Once economies re-opened, monetary conditions were super loose. Demand surged and there were constraints to meet that demand as people were still off sick or had to undergo lockdowns due to covid in some parts of the world.

It brings us to another economic concept called potential GDP. GDP or gross domestic product is probably the most well-known measure of economic performance. It is essentially all the output that is produced in the economy. Potential GDP is a somewhat theoretical concept, but it refers to all the output that could be produced by all the labour and capital in the economy at their maximum sustainable rate, without causing inflation. If you think of this in practical terms, potential GDP would mean all factory workers, hairdressers, lawyers etc., worked as much as they could, had their schedules completely filled up with clients and everyone in the economy who wanted a job had a job. But if demand were stronger than this; if we demanded more goods than what the factory workers could make, or if more people wanted services from hairdressers or lawyers, then prices would go up, hence inflation would result. In this latter case, GDP would be exceeding the theoretical potential GDP.

Over the past year, we have seen signs of prices rising and capacity constraints, in part because COVID and the Ukraine war has limited the ability to produce the output demanded by the world at current prices. In relation to our discussion on potential GDP, these major events may have resulted in lower potential GDP than if COVID never came along. For much of last year, the US Federal Reserve along with other central banks were of the view that these constraints would be temporary. However, there are now more signs that these capacity constraints are more persistent, and a low unemployment rate in many advanced economies also signals that those respective economies might be growing at close to potential or even above for a sustained period.

It is why tough talk on inflation by the US Federal Reserve has raised all sorts of concerns in financial markets and lifted the prospect of a US recession. Because for inflation to come down, the economy would likely need to slow to a point below potential to do so, it may need to raise interest rates significantly to put the brakes on the economy.

Of course, there remains the argument that capacity constraints are still temporary, such as covid lockdowns in China weighing on supply chains. Nonetheless, it is also most likely the case that these constraints may persist for a little while longer. On top of this, low unemployment rates further highlight that economies do not need interest rates at extremely low levels.

So, there it is. This is why central banks have used interest rates, among other policy tools, to influence inflation. And with inflation still high in many parts of the world, interest rates could rise even further.

Originally published at https://bitesizedeconomics.com.